Fed's failure to communicate adds to risks

WASHINGTON (MarketWatch) -- As the clouds of economic worry have moved over the nation since August, the Federal Reserve under Ben Bernanke has fumbled badly in realizing its objective to communicate clearly with the financial markets.

The result has been a deep nostalgia in financial markets for the old winks and nods contained in the inscrutable remarks of former Fed chief Alan Greenspan.

But more importantly, Fed watchers charge the communication woes have caused the Fed to miss opportunities to bolster confidence, which could be a key factor in whether a downturn morphs into a recession.

While the Fed has been steadily easing monetary policy, by one percentage point since the turmoil began, at the same time the central bank has been talking tough on inflation. This "verbal tightening" has undercut its actual policy easing, said Ethan Harris, chief U.S. economist at Lehman Brothers.

"The market isn't sure whether the Fed is really going to provide help in an emergency and so there is a lingering question if they are ready to cut if the economy weakens substantially," Harris said. "The Fed has created that concern by continuing to focus on inflation and at times sounding like they were completely out of touch with what the markets are thinking."

Lyle Gramley, a former Fed governor, now at Stanford Policy Research, agreed: "Right now, the Fed is having communications problems with the market...Markets are a little confused. It is this going-back-and-forth that bothers the market," he said.

The do-one-thing-say-another pattern started in early August when the Fed, despite signs of distress in capital markets, held interest rates steady and announced a tough anti-inflation posture. But within a matter of days, the central reversed course and cut the discount rate.

The pattern has been repeated several times, most recently in November, when the Fed officials insisted they would not cut rates at the December meeting of the Federal Open Market Committee, even if the credit conditions deteriorated. But the FOMC, of course, eventually decided to cut rates.

Gramley said that financial market participants constantly ask him if the Fed "really gets" the credit crunch and if Bernanke is up to the job.

In perhaps the biggest communications gaffe, the Fed was widely criticized for only cutting rates a quarter percentage point on Dec. 11. Then the next morning, the central bank introduced an innovative periodic auction of loans to banks. This announcement was met with applause and a market rally.

"Something is strange," said Western Carolina University economist James F. Smith, a long-time Fed watcher. "The Fed probably could have saved a lot of grief if they had added something [about the auction plan] to their policy statement," on the previous day, he said.

"It is a mystery why on earth they didn't do that. Undue market turmoil is not generally something the Federal Reserve System likes to create," he added.

Analysts said it is crucial for the Fed to be more careful in their communications with the market.

"The key here is confidence. They need to shore it up. The window is closing. They had a couple of chances and they may only have one more," said Mark Zandi, chief economist for Moody's Economy.com.

Consensus approach

Fed watchers said the confusion may stem from the consensus nature of the Bernanke Fed. In contrast to the iron hand of Greenspan, Bernanke allows the committee debate to flow freely.

"This Fed, because it is more consensus-oriented, is having a harder time finding its voice, Zandi said.

Zandi said it appears that Bernanke is leaning towards easing while others on the central bank are not so keen to lower rates.

"Maybe there is a lot of difference of opinion among Fed officials about what is happening in the economy and what ought to be done about it. When you have a committee process, that could lead to a failure to take a strong enough position," Gramley said.

"I don't think this Fed can come to clear consensus quickly on being aggressive in response to the crisis, and, as such, I think the odds of a recession are higher than would otherwise be the case," Zandi said.

"You do get nervous...when you see the Fed act in a fairly determined manner to kind of get markets back on course and it doesn't seem to work," Harris said. "Some of their ammunition is getting a little wet," he said.

Zandi says the Bernanke Fed feels "more academic, and more hawkish" than the Greenspan Fed and is looking toward the long-run. In monetary policy, the hawks are seen to be more concerned with fighting inflation, while doves are considered to be more pro-growth and more tolerant of a whiff of inflation.

Harris said there is an "almost populist" view on Wall Street that Bernanke is too academic and out of touch. But he said that careful observers don't blame the Fed for the recent credit crunch.

Hawks coming on board

Some analysts said the problem could be exacerbated in 2008 when the poster-child for the more hawkish Fed, Philadelphia Fed President Charles Plosser, becomes a voting member of the FOMC under the normal rotation. Five of the 12 bank presidents are voting members in any year.

"Plosser is a let's-do-anything-to-make-sure-we-never-have-inflation-again person. He is going to be difficult to convince on the need for continuing to drop the fed funds rate," said Smith.

Plosser recently said that if there is going to be a recession, there is little the Fed can do.

"That certainly is different from what I heard from the Greenspan Fed," Zandi said.

Plosser will be joined by Gary Stern, the longest serving president of the Minneapolis Fed. In addition, Susan Pianalto, the president of the Cleveland Fed, and Richard Fisher, the president of the Dallas Fed bank, will become voting members.

None of these officials would be characterized as doves.

One dove, Boston Fed President Eric Rosengren, who favored a half-point cut in December, will rotate out of a voting seat. The other presidents who lose their votes are Chicago Fed President Charles Evans, Kansas City Fed President Thomas Hoenig and St. Louis Fed President William Poole.

Mike Englund, chief economist at Action Economics, said the new FOMC will "clearly" be more hawkish. In fact, Englund thinks the 2008 FOMC could quickly find that rates are too low and reverse direction if it was clear that the economy were out of the woods on the credit turmoil.

But some Fed watchers contend it makes no difference who is a voting member.

"Normally speaking, who votes and who doesn't vote makes no difference at all," Gramley said. "It is a committee process, and people get to speak their mind whether they are a voting member or not."

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.